Who Pays the Tax?

Who bears the burden of a tax? Buyers or sellers? Why is it that the more elastic side of the market will pay a smaller share of a tax. Again, we’ll apply what we know to the example of Social Security taxes and also look at the health insurance mandate as a part of the Affordable Care Act. Who pays for the mandate? The employers or the workers? We’ll also look at supply and demand of labor. Is the demand for labor more elastic than the supply?
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- In the last lecture, we showed that the
legal incidence of a tax does not

determine the economic incidence. In this
lecture, we're going to talk about how the

economic incidence of taxes actually is
determined. Who bears the burden of

a tax?

Here is the rule for the economic
incidence of a tax. The more elastic

side of the market will pay a smaller
share of the tax, a smaller burden.

Similarly, the less elastic side of the
market or rather the more inelastic side

of the market will pay a greater share of
the tax. So more elastic pays a smaller

share, less elastic pays a greater share.
I'm going to show you this in a couple of

diagrams and then give you the intuition
for why it's the case. Let's suppose we

can't remember the rule. Is it the more
elastic side which bears the smaller share

of the tax or the greater share of the
tax? Say we can't quite remember. Well, no

problem. Let's just draw the diagram and
read it off as it happens. For instance,

let's draw a diagram which has a pretty
elastic demand curve and relatively

speaking a pretty inelastic supply curve.
Here's the price when there's no tax. Now

let's look at what happens when there is a
tax and we'll use our wedge method. Here's

the tax and the height of the wedge gives
us the amount of the tax. What do we do?

We drive this wedge into the diagram until
the top of it hits the demand curve and

the bottom of it hits the supply curve and
then we just read the answer off our

diagram. Point B, this tells us the price
paid by the buyer. Point D, this tells us

the price received by the seller. Let's
compare. When there was no tax, the price

paid by the buyer was at A and with the
tax the price to the buyer goes up a

little bit to point B.
The buyer isn't paying much of a higher

price. On the other hand the seller is
receiving a lot less. In this case, when

demand is more elastic than supply, the
demanders pay a smaller share of the tax

and the suppliers pay a larger share.
Therefore we can just read off the diagram

what happens when demand is more elastic
than supply. You don't have to remember

the rule, you don't have to memorize it
because I'm going to give you some

intuition to make it easy in just a
moment. You simply have to draw the

diagram and be able to read the answer off
the curves. Let's look at another case. In

this case, we've drawn a supply curve
which is very inelastic and a demand curve

which is less elastic than the supply
curve. Once again we're going to take our

tax wedge, we're going to push it into the
diagram and what happens? You can see it

right here. We just have to read it off
the diagram. Now we see that compared to

when there was no tax, the price to the
buyer has gone up a lot and the price to

the sellers has gone down by just a little
bit. When the supply is more elastic than

demand, buyers pay the greater share of
the tax, that is the price to the buyer

goes up more than the price to the sellers
goes down. The buyers pay more of the tax

when the supply curve is more elastic.
Let's give some intuition. You can always

get the right answer by drawing the
curves. And let's consider the intuition

for why that's the case. So here's the
intuition for remembering the rule. Think

about elasticity as a kind of escape. The
side of the market which is the more

elastic can escape the tax more easily.
Why does that makes sense? Remember what

elastic demand means. It means that
demanders have good substitutes for the

taxed good and so they can escape the tax.
When the tax is high, the demanders are

going to say, "We're just going to go buy
the substitutes. We have plenty of good

substitutes." On the other hand, think
about what it means when the demand is

inelastic. It means that there are no good
substitutes so it's hard to escape to tax.

What about the supply side, elastic
supply? Well, that means the resources

which are used to produce the taxed good,
they can easily be moved to other

industries. The resources can move around
easily. If you try to tax the industry a

lot then the land, the capital, the
workers in that industry which were used

to produce the good, they're just going to
flow to other industries and so the

suppliers can relatively easily escape the
tax. On the other hand, if supply is

inelastic that means the resources used to
produce this good, they really can only be

used to produce this good. They're fixed,
they're hard to move around, and those

factors are not that useful for producing
other goods, so that makes it difficult

for the suppliers when the supply curve is
inelastic. That means it's difficult for

the suppliers to escape the tax. What if
the demanders and the suppliers are both

pretty elastic? Well, here's the thing.
Somebody has to pay the tax, both sides

can't escape the tax at least if the good
is going to be bought and sold, therefore

the burden is determined by the relative
elasticities. It's about which side has it

easier to escape the tax and that side
will pay less of the tax. The side which

is less elastic, they're going to pay more
of the tax because that side finds it

harder to escape the tax. So let's do an
application, say social security taxes.

Last time we showed that the legal
incidence of social security taxes has no

bearing on the economic incidence but we
didn't say what the economic incidence

actually is. So let's do that now. We're
going to have the price of labor up here,

the wage, and the quantity of labor down
here. The whole question now boils down to

is the demand for labor, more elastic than
the supply of labor or vice versa? Think

about the demanders of labor, businesses,
what substitutes for labor do they have?

If the price of labor goes up, what can
those businesses do?

What about the supply of labor, the
workers? If their wage goes down, what can

they do? If you think about it I think
you'll see that for most workers,

especially full time workers, they don't
really have a lot of good substitutes for

work. Most workers need some kind of job.
Even if their wage goes down they're going

to continue to work because they need to
pay the bills. On the other hand, the

demanders of labor if the wage were to go
up, they could substitute capital for

labor, they could move their investments
to other countries. They have quite a few

good substitutes. So if that's actually
how it works we should probably draw the

diagram like this with a fairly inelastic
supply of labor and a fairly elastic

demand for labor. Economists have done
studies of this and on average this is

what they find. So now think about your
FICA taxes, that's a tax on labor. What's

the effect of that? Well, it's going to
look something like this. Notice that the

wage paid by buyers of labor, that's the
wage paid by the firms that goes up only a

little bit. On the other hand, the wage
received by the suppliers of labor, that

is the wage which the workers end up with,
that goes down by a lot. And this makes

perfect sense when we have a very
inelastic supply of labor. The laborers

can't escape the tax and therefore they
end up bearing most of the burden of the

tax. This doesn't mean by the way that we
shouldn't have social security taxes. It

may in fact be a good way of forcing
people to save for their own future but

this does mean it is not a free lunch for
the workers. The workers' wages will

drop because of the tax. If we didn't
have the social security tax, wages for

most workers would in fact be higher.
Here's one more application, health

insurance mandates. Suppose that the
government requires employers to provide

health insurance to their workers as is
now the case for many employers under the

Affordable Care Act. Who's going to pay
for this? Who will end up paying for this?

Is it primarily the employers or primarily
the workers?

It's really just the same analysis as we
had before. A health insurance mandate is

quite similar to a tax. A health insurance
mandate simply means that the employers

have to pay a higher wage but that's just
then the same as the tax. What we just saw

is that if labor supply is less elastic
than labor demand, which in many cases

makes sense, then in that case most of the
mandate will actually be paid for by the

workers. Real wages will fall. Again this
doesn't necessarily mean that the mandate

is a bad idea but it does mean it's not a
free lunch for the workers. The workers

end up paying for their health care
through the medium of lower wages. Taxes

have a couple of other effects including
the raising of revenue and also creating

some dead weight loss. Those are what
we're going to look at in the next

lecture.

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